Is The Stock Market Just A Side Show? Evidence Form Venture Capital
Bibo Liu
PBC School of Finance, Tsinghua University
Xuan Tian
Indiana University – Kelley School of Business – Department of Finance
May 17, 2016
Abstract:
We examine the real effects of financial markets from the perspective of venture capital (VC) investors. We postulate that VCs actively learn information contained in public market stock prices when designing investment structure in their startup ventures. We find that, when public market prices are more informative, VCs are less likely to stage finance startup ventures and to syndicate with other VCs to save the costs associated with staging and syndication. This effect is more pronounced when VCs are lack of industry-specific expertise, VCs are physically distant from their ventures so that collecting soft information is costly, and their investments are less risky. Using exogenous events that unexpectedly alter financial analysts’ and short sellers’ ability to produce information, which makes public market prices less informative, we show that our results are unlikely driven by endogeneity. Our paper sheds new light on the real effect of financial markets by showing that private equity investors actively learn information from public equity market prices.
Is The Stock Market Just A Side Show? Evidence Form Venture Capital – Introduction
Is the stock market just a side show or does it have real effects on economic activities? Conventional wisdom believes that stock market security prices merely reflect expectations about future cash flows. However, a growing strand of literature in financial economics challenges this traditional view by both theoretically arguing for and empirically documenting evidence about the real effects of secondary stock markets on corporate decision making. Specifically, following the insightful work of Hayek (1945), which posits that prices are a useful source of information, recent theories (e.g., Grossman, 1976; Hellwig, 1980; Dow and Gorton, 1997; Subrahmanyam and Titman, 1999; Goldstein and Guembel, 2008) argue that while individual market participants may be less informed than managers, financial markets as a whole have the ability of aggregating different pieces of information possessed by various market players and incorporating them into security prices. Consequently, managers of publicly traded firms can learn from the information in stock prices about the prospects of their own firms and use this information to guide their real investment decisions.
While the above argument is very compelling, empirically testing the argument is challenging, because the information set possessed by managers of publicly traded firms is not observable to econometricians. As a result, even if one observes a firm’s security price informativeness is positively related to its subsequent investment activities, it is difficult to disentangle whether it is managerial learning from stock prices or stock prices passively reflecting what managers have already known about their investment opportunities. To alleviate this concern, in this paper, we focus on the investment decisions made by venture capital (VC) fund managers and examine whether VC fund managers learn from public market equity prices and use the information to guide their investment in startup companies.
Venture capital provides an ideal research setting that offers several unique but important advantages. First, startup ventures funded by VC investors are private companies whose shares are not publicly traded and do not have a stock price. Hence, it is unlikely that venture-specific information known by VC fund managers is reflected into the stock prices of public firms, even though the public firms are in the same industry as the startup venture. Hence, the concern that stock prices of public firms being a passive reflection is mitigated in the VC setting. Second, VC fund managers have great incentives to learn from the public market. VCs invest in early-stage startup ventures that have high growth potential but also substantial failure risk. VC industry is characterized as being full of information asymmetry between investors and entrepreneurs. Hence, before making investment decisions, VC fund managers have larger incentives to learn from the public market than public firm managers who possess more information and suffer from information asymmetry problems to a less extent. Finally, VC staging and syndication, unique features of VC investments from public firm investment, provide a variety of dimensions that allow us to better understand how precisely the information learnt from the public market affects VC fund managers’ investment decisions in startup ventures.
To exploit the unique features of venture capital investment, we focus on VC stage financing and syndication in this paper. The staging of capital infusion by VC fund managers is the stepwise disbursement of capital from VC investors to startup ventures. It is an effective tool used by VCs to mitigate information asymmetry and agency problems because it can keep entrepreneurs “on a tight leash” (Sahlman, 1990; Gompers, 1995). However, as argued in Tian (2011), stage financing is not a free lunch but costly. Potential costs arising from VC staging include negotiation and contracting costs in each round of financing, forgone economics of scale due to divided capital infusions, induced short-termist behavior on the part of entrepreneur, and underinvestment in early-stage ventures. Hence, if pubic market stock prices are more informative so that VC fund managers can more effectively learn, we expect that they will stage finance less to save the cost of staging. We develop three measures to capture VC staging: the number of rounds that is the total number of financing rounds a startup venture receives from its VC investors; investment skewness that is the amount an startup receives from the first round divided by total amount it receives across all financing rounds; change in round amount that is the difference in investment amount a venture receives form the current round and from the previous round. If our argument is supported, we expect to observe that a venture capital fund managers tend to invest fewer rounds, invest more in the first round, and increase round amount if the stock prices of public firms in the same industry of their ventures are more informative.
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